Social security in America has been around since FDR signed the Social Security Act into law in 1935, during one of the darkest periods in U.S. economic history – the Great Depression. It is a forced retirement savings program, that is funded by worker contributions via FICA taxes. Typically, FICA taxes are deducted from your paycheck and go towards funding your social security trust account as well as Medicare insurance. If you work for a company in America, about 7- 7.5% of your paycheck goes to paying FICA taxes – and your contributions must be matched by your employer by law. If you work for yourself, then you are responsible for paying FICA taxes, which amount to about 15% of your gross income.
Social security is a guaranteed lifetime retirement income plan, that’s supposed to keep up with the rate of inflation. In practice, however, the benefits you receive are earning U.S. government bond yields, which in fact guarantees negative real rates of return. This means that your social security benefits are losing value to inflation over time. This is my main criticism of this forced retirement savings plan – it’s a poor investment returns, not that it will run out of money by 1934 – which is a great concern as well, but not as threatening as it sounds.
Things change over the years, and while the original law’s intentions may have been good for the average retiree in America, today things don’t look as good for social security. There are some serious problems with the design and implementation of the social security program, all which point to a serious need to come up with alternative strategies for individuals.
The first major problem is the distinct possibility that the social security trust fund may run out of money within 16 years from now.
The chart above was taken from a think-tank at George Mason University. It is one among many studies that show that the social security trust fund is likely to go bust by the year 2033 unless some serious changes are made. If we continue on the present track, there will not be enough money in the trust to pay fully for retiree benefits. There are a number of reasons for this, but the main reasons are due to:
- Ever-increasing longevity rates – people are living longer, so more people will need retirement benefits than are paying into the system
- Birth rates are declining – which means that there are less people in the workforce to pay for the benefits going to retirees. Combine this with longer lifespans and you have a deficit in the making, as far as the social security trust fund budget is concerned.
- The current FICA tax structure (the part of your income that gets taxed to pay for social security and Medicare) does not tax wealthy earners enough as a percentage of income in comparison to workers in lower tax brackets
- The returns on investment (ROI) generated by the social security trust fund is so low that it will never be able to cover real expense needs by the time we retire
- Money from thesocial security trust has actually been tapped to pay for a host of other federal expenses – IOUs have actually been drawn on the money in the social security trust!
Will social security benefits be completely wiped out by the time current workers retire?
The answer is not likely, since the federal government will most likely find a last minute solution to keep the system afloat. The alternative would be complete chaos and revolution. No political party would ever be forgiven for destroying such a sacrosanct entitlement program as social security. Therefore, what Congress is likely to do to patch up the system will likely include any or all of the following steps:
- Raise the full benefit retirement age (currently age 67 for those born after 1960) to something much higher, say 73. This is likely because people are indeed living longer.
- Raise social security FICA taxes (especially on higher income earners) by 3% or so – studies show that this level of a FICA tax hike would be sufficient to keep the system afloat
- Lower COLAs (cost of living adjustments) – these are upward % adjustments in benefits that occurs every few years. COLAs notoriously lag way behind the average rate of inflation in America (the long-term average rate in the U.S. is 3% per year). By lowering the rate of COLA adjustments even more, the government will reduce the negative real return on funds in the social security trust even further
- Reduce or even eliminate payouts to wealthy high net worth retirees (who really don’t need their social security benefits anyway)
As mentioned, any or all of these measures are likely to be taken by Congress eventually to keep the social security system afloat. So the question is not whether social security will go bust, but rather whether most Americans can even rely on the payouts to cover the cost of living expenses during retirement.
The answer to that more important question is clearly negative. Most financial advisors agree that the average retiree needs roughly 70% of their income during working years to cover living expenses during retirement. So if you were making $50,000 (or $4,167 per month) gross in the year prior to retirement, you would need $35,000 per year (or $2,917 per month), to cover lifestyle expenses during retirement.
The first red flag is that the average payout per month for social security benefits is a measly $1360 – nowhere near what the average retiree can rely on. Indeed, the average payout from social security today covers only about 33% of living expenses for the typical retiree.
As mentioned above, this measly average payout of $1,360 is likely to be chopped even further, as meager COLA adjustments that can’t keep up with the rate of inflation – and equally important – as the federal government continues to do a poor job managing the money in the social security trust fund. I think anyone and everyone would agree that the federal government should never have gotten involved in the pension fund management business. Keep in mind that the Social Security Act was passed in 1935, a time when the financial markets were in a primitive phase. More than 80 years later, we have experienced a revolution in personal investing as commission costs have fallen dramatically and ETFs and index funds have come to the fore. More than ever, we have the tools in place where ordinary individuals can harness the power of compound investment growth to retire rich. We have tens of thousands of ETFs and index mutual funds to choose from – all a mouse-click away. Instead, social security limits us to an investment allocation from the Stone Age – thereby denying ordinary individuals the right to harness the power of compound growth at respectable rates, in effect suppressing our rights to retiring wealthy.
It is high time that the federal government was fired as an investment manager and that this responsibility be returned to individuals. Why nobody complains to their Congressional leaders about this is beyond me. Everyone seems to accept the Social Security program as axiomatic – without even questioning its purpose and validity.
At best, the social security system today is a failure – and it will only get worse.
Here’s my brief recommendation: keep mandatory saving for retirement in place (by federal law), but adopt a mandatory conservative asset allocation model with target time horizon according to the age of the individual. Let individuals choose from 3 institutions (like a Schwab, Fidelity or TD Ameritrade, e.g.), where their individual retirement accounts reside and at which they can opt for a conservative asset allocation model.
Another option would be to replace social security entirely with a retirement program like the Roth IRA. Make Roth IRA contributions mandatory – but have strict conservative guidelines in place so that individuals don’t put everything in risky assets like stocks. Allow individuals who want to save more than the minimum FICA tax contributions to invest the way they want (in riskier allocations e.g.), but as far as the contributions toward their personal social security account is concerned, they must adopt a conservative investment allocation – one that limits exposure to stock funds to 25% e.g. – the rest must be invested in investment grade bonds like U.S. treasuries.
One of the key points that will learn later on in this book, is that the overall asset allocation of your retirement money is one of the most important decisions that an investment manager must make. While a diversified stock portfolio is a great long-term investment, an investment portfolio that is 100% in stocks is too much risk for any individual investor to take. Anyone with a time horizon less than 20 years should definitely not be 100% in stocks. I always cite the example of history: if you poured $100,000 into a portfolio of U.S. stocks in 1928, by 1932 that stock portfolio would have been worth a mere $15,000. Of course, the stock market did manage to claw its way back – but it took more than 25 years to recover from the 1929 crash.
On the other side of the investment spectrum we have bonds – investment grade bonds, that is. The bonds, notes and bills issued by the U.S. government are AA rated, which is investment grade by any standard, and they performed great during the Great Depression. As bonds do well during recessions and depressions, they are a great way to off-set the risk of a stock portfolio while generating income at the same time. Only problem is that in low inflation periods such as the one we’re in currently, not only are the yields really low (lower than the rate of inflation), but as interest rates rise, these bonds will lose value. Investment grade bonds simply do not protect investors from inflation risk. These days, the yield on a 10-year U.S. treasury bond is about 2.5%, which is lower than the average long-term rate of inflation in the U.S. (3%). So if you’re 100% allocated to bonds, as the social security trust is,you’re getting negative real returns on your retirement money. There is simply no way that the social security trust fund can ever provide good enough returns to fight inflation.
One of the key solutions to keep the social security trust fund alive and well while generating sufficient real returns for future retirees is to change the overall asset allocation from a lop-sided one that is 100% in investment grade bonds to one that incorporates equity (stock) index funds. The optimal mix of stocks and bonds – based on over 90 years of historical data – is readily available. We will cover the optimal asset allocation in a later chapter of this book. I call the optimal mix the WealthMaxBuilder portfolio. It should be read by the federal government officials in charge of managing the social security trust fund as well by Congressional leaders.
Until then, individual investors would be better off taking their retirement investment strategy in their own hands by applying the WealthMaxBuilder portfolioprinciples. All it takes is setting up a Roth IRA at an established brokerage firm like Schwab, Fidelity or any major commercial bank for that matter. I will explain how to set up such an account and how to implement the WealthMaxBuilder portfoliostrategy from start to finish.
One of the most important decisions a retiree in America must make is when to begin receiving social security benefits. I will not go into great detail in this book about this matter except to say that the longer you wait (up until the forced distribution age of age 70), the more you’ll receive. The actual amount increases by 8% per year, for every year you wait until age 70. Certainly deciding to receive social security benefits early on in retirement (the earliest age is 62) is likely to be a mistake if you’re in good health and have high probability of increased longevity – because your benefits are reduced by 25%. Obviously, the higher your chances of longevity, the more it pays to wait until close to the maximum age, as your benefits increase by 8% per year until the mandatory distribution age of 70.
The key point is that even if you wait until age 70 to get the maximum benefit, social security will still be an insufficient means of building wealth for a secure and comfortable retirement. It’s not a surprise that the federal government can’t be relied on for something such as important as this. Instead, we should take the bull by the horns and take responsibility ourselves. Keep in mind that it is YOUR retirement assets we’re talking about. These are your hard earned contributions. The money does NOT belong to the federal government.
What the Feds are doing with YOUR retirement money should be in fact be considered illegal and unconstitutional.
The security of your retirement assets is in your own hands. It is high time to reclaim the right to manage your retirement assets properly.
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